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To Hedge or not to Hedge : Hedge or Mutual

By Ali Jaffery

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After three years of stock-market declines, hedge funds are appealing to more and more investors. These funds, which offer the potential of making money in any market environment, are growing both in terms of number of portfolios and size of assets. Hedge funds returned an average of 0.2% last year and an average of 11.2% annually for the past three years. The average U.S. diversified stock mutual fund lost 22.4% in 2002 and dropped an average of 11.7% for the past three years.

 

Traditionally, hedge funds have been off limits for many mutual-fund investors. Because of the risks involved Hedge funds in the past were sold almost exclusively to only a limited number of wealthy investors who presumably didn't need all of the government and financial-industry protections provided to mutual-fund buyers.

 

No more. Now there are funds of hedge funds. These funds have lower investment minimums than the individual hedge funds themselves and each can sign up a greater number of investors.

 

While hedge funds are entering the investment mainstream, there have been a number of recent failures at high-profile hedge funds. Gotham Partners Management Co. closed its biggest hedge funds earlier this year after sudden real-estate losses. And US federal prosecutors have launched a criminal investigation into Beacon Hill Asset Management LLC, a hedge fund that lost more than 50% of its value last fall through bets made in the mortgage-backed securities market.

 

So what's the difference between mutual funds and hedge funds? Much of the following applies to both closed-end mutual funds, which trade like stocks on exchanges, as well as to open-end mutual funds, but it focuses on the more popular open-end funds.

 

Both mutual funds and hedge funds are baskets of securities. Investors don't directly own the securities in the basket but buy and sell an interest in the basket itself. But mutual funds are organized as investment companies while hedge funds are organized as limited partnerships. The general partner in a hedge fund, who manages the portfolio, normally has a significant personal investment in the fund. Even with some notable exceptions, that typically isn't the case for mutual-fund managers.

 

Hedge-fund managers usually try to make money irrespective of whether the stock and bond markets are rising or falling. By comparison, most mutual-fund managers have trouble showing gains when markets are declining for extended periods. Rather than measuring whether or not they make money for their investors, mutual funds most often gauge their success or failure by comparing their performance to an appropriate market index. Gain more -- or lose less -- during the year than the Standard & Poor's 500-stock index, for example, and stock mutual-fund managers receive kudos, and often bonuses, based on their relative performance. Success for hedge-fund managers, on the other hand, requires them to show real gains for investors or their pay will be cut.

 

That doesn't mean hedge funds make money in all market conditions. Some salespeople have misled investors by saying hedge funds never have down years. That's led to a lot of disappointed expectations. While a hedge-fund manager is always focused on absolute return, he's not always going to do it.

 

To generate positive returns, hedge-fund managers use a range of investing tools, such as short selling and leverage, that typically are used to just a limited degree by mutual funds. But while these tools can be used to "hedge" against declines in markets -- giving hedge funds their name -- they also can involve substantial risk.

 

While some mutual funds have a limited ability to sell stocks short and to leverage, meaning to invest with borrowed money, hedge funds can play to their hearts' content, Because of that, mutual funds tend to be long only, buying stocks or bonds, while hedge funds can use a variety of strategies.

 

Hedge funds often combine long and short positions to exploit differences in the price of a single security that trades in more than one market or differences in the prices of two securities that are issued by the same company or entity or have some other relationship. When these pricing differentials are tiny, a fund may borrow money in order to increase the size of its bets. This can lead to bigger profits if the prices move in the direction a fund manager anticipates, but it can magnify losses if the manager gets it wrong.

 

Hedge funds tend to concentrate their portfolios in fewer investments than the average diversified mutual fund, another factor that can contribute to risk. And while mutual funds generally invest in securities of publicly traded companies that are the easiest to buy and sell, hedge funds may invest in securities of distressed companies that trade infrequently or in securities of privately held companies that rarely change hands.

Hedge funds have more leeway than mutual funds to "time" the market, putting money to work when they see opportunities to profit and moving large portions of their portfolios into cash when the going gets tough. By comparison, many mutual-fund managers feel obliged to remain fully invested regardless of the market environment.

 

Unlike mutual funds, which are highly regulated, hedge funds aren't required to meet most the registration and disclosure requirements, so many of the protections that investors have come to expect in mutual funds are missing.

 

Getting money out of hedge funds can take time. Unlike the daily withdrawals allowed by most mutual funds, many hedge funds lock investors' money up for a year or more, and then buy back limited partnership interests only a few times a year.

Hedge funds also charge much higher fees than mutual funds. In addition to a management fee of 1% or 2% of assets charged regardless of performance, hedge-fund managers typically keep between 15% and 25% of any profit they make for investors. Funds of hedge funds charge their own management fees of 1% of assets and performance fees of as much as 10% on top of those charged by the underlying managers. Add in the sales charges and distribution fees that smaller investors typically pay, and a fund of hedge funds has to make a lot of money before investors break even.

 

On the plus side for investors, hedge-fund managers can charge a performance fee only if they make money, so their interests are aligned with those of their clients. And if a hedge fund loses money, it has to make investors whole again before it can levy the performance fee in the future. This practice is known in the industry as a "high-water mark." Mutual-fund companies, by comparison, usually charge the same fees whether the fund makes money or not.
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